<DOC>
[109th Congress House Hearings]
[From the U.S. Government Printing Office via GPO Access]
[DOCID: f:41850.wais]
NATURAL GAS ROYALTIES: THE FACTS, THE REMEDIES
=======================================================================
HEARING
before the
SUBCOMMITTEE ON ENERGY AND RESOURCES
of the
COMMITTEE ON
GOVERNMENT REFORM
HOUSE OF REPRESENTATIVES
ONE HUNDRED NINTH CONGRESS
SECOND SESSION
__________
MARCH 1, 2006
__________
Serial No. 109-251
__________
Printed for the use of the Committee on Government Reform
Available via the World Wide Web: http://www.gpoaccess.gov/congress/
index.html
http://www.house.gov/reform
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COMMITTEE ON GOVERNMENT REFORM
TOM DAVIS, Virginia, Chairman
CHRISTOPHER SHAYS, Connecticut HENRY A. WAXMAN, California
DAN BURTON, Indiana TOM LANTOS, California
ILEANA ROS-LEHTINEN, Florida MAJOR R. OWENS, New York
JOHN M. McHUGH, New York EDOLPHUS TOWNS, New York
JOHN L. MICA, Florida PAUL E. KANJORSKI, Pennsylvania
GIL GUTKNECHT, Minnesota CAROLYN B. MALONEY, New York
MARK E. SOUDER, Indiana ELIJAH E. CUMMINGS, Maryland
STEVEN C. LaTOURETTE, Ohio DENNIS J. KUCINICH, Ohio
TODD RUSSELL PLATTS, Pennsylvania DANNY K. DAVIS, Illinois
CHRIS CANNON, Utah WM. LACY CLAY, Missouri
JOHN J. DUNCAN, Jr., Tennessee DIANE E. WATSON, California
CANDICE S. MILLER, Michigan STEPHEN F. LYNCH, Massachusetts
MICHAEL R. TURNER, Ohio CHRIS VAN HOLLEN, Maryland
DARRELL E. ISSA, California LINDA T. SANCHEZ, California
JON C. PORTER, Nevada C.A. DUTCH RUPPERSBERGER, Maryland
KENNY MARCHANT, Texas BRIAN HIGGINS, New York
LYNN A. WESTMORELAND, Georgia ELEANOR HOLMES NORTON, District of
PATRICK T. McHENRY, North Carolina Columbia
CHARLES W. DENT, Pennsylvania ------
VIRGINIA FOXX, North Carolina BERNARD SANDERS, Vermont
JEAN SCHMIDT, Ohio (Independent)
------ ------
David Marin, Staff Director
Rob Borden, Parliamentarian
Teresa Austin, Chief Clerk
Phil Barnett, Minority Chief of Staff/Chief Counsel
Subcommittee on Energy and Resources
DARRELL E. ISSA, California, Chairman
LYNN A. WESTMORELAND, Georgia DIANE E. WATSON, California
ILEANA ROS-LEHTINEN, Florida BRIAN HIGGINS, New York
JOHN M. McHUGH, New York TOM LANTOS, California
PATRICK T. McHENRY, North Carolina DENNIS J. KUCINICH, Ohio
KENNY MARCHANT, Texas
Ex Officio
TOM DAVIS, Virginia HENRY A. WAXMAN, California
Lawrence J. Brady, Staff Director
Dave Solan, Professional Staff Member
Lori Gavaghan, Clerk
Richard Butcher, Minority Professional Staff Member
C O N T E N T S
----------
Page
Hearing held on March 1, 2006.................................... 1
Statement of:
Cruickshank, Walter, Ph.D., Deputy Director, Minerals
Management Service, Department of the Interior............. 13
Letters, statements, etc., submitted for the record by:
Cruickshank, Walter, Ph.D., Deputy Director, Minerals
Management Service, Department of the Interior, prepared
statement of............................................... 24
Issa, Hon. Darrell E., a Representative in Congress from the
State of California, prepared statement of................. 3
NATURAL GAS ROYALTIES: THE FACTS, THE REMEDIES
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WEDNESDAY, MARCH 1, 2006
House of Representatives,
Subcommittee on Energy and Resources,
Committee on Government Reform,
Washington, DC.
The subcommittee met, pursuant to notice, at 2:07 p.m., in
room 2154, Rayburn House Office Building, Hon. Darrell E. Issa
(chairman of the subcommittee) presiding.
Present: Representatives Issa, Watson, and Higgins.
Staff present: Larry Brady, staff director; Lori Gavaghan,
legislative clerk; Thomas Alexander, counsel; Dave Solan, Ph.D.
and Ray Robbins, professional staff members; Alexandra Teitz,
minority counsel; Richard Butcher, minority professional staff
member; and Cecelia Morton, minority office manager.
Mr. Issa. Good afternoon. A quorum being present, I call
this hearing to order.
This subcommittee is conducting a fact-finding hearing to
investigate the implementation of the Federal Natural Gas
Royalty Payment Program.
Recent news reports suggest that the Government may be
unable to collect anywhere from $7 billion to $28 billion in
natural gas royalties from leases of Federal lands and waters.
This is particularly troublesome at a time when natural gas
companies are continuing to post record earnings.
There are several areas of concern, the first is whether
some gas companies have failed to fulfill their contractual
obligations to make royalty payments to the Department of the
Interior.
There is confusion surrounding figures the industry has
supplied to the Interior Department, the accounting methods of
the Interior Department, and the degree of oversight provided
by Minerals Management Service [MMS].
On this basis alone, the U.S. Government may have been
underpaid $700 million worth of royalties in 2005.
Second, there is concern that the United States could be
excluded from billions of royalties resulting from the Deep
Water Royalty Relief Act. The act was enacted to provide an
incentive to companies to explore and extract oil and natural
gas from the U.S. waters. This came at a time when oil and
natural gas prices were low, and the interest in deep water
drilling was lacking.
The act gives the Secretary of the Interior the authority
to enter into leases with oil and gas companies with defined
volume suspensions and price thresholds so that companies can
recover their capital investments before paying royalties on
the gross revenues.
Again, this was at a time in which prices were low.
During 1998 and 1999, however, these critical price
thresholds were not included as terms of the leases, thereby
allowing companies to recoup their capital investments long
before the expiration of volume suspensions.
As these wells are now beginning to reap billions in gross
revenues because of record gas prices, the effect of the price
threshold-free language is coming to fruition.
As a result, the United States may be unable to claim part
of the billions in gross revenues for the years 1998 and 1999.
The Department of Interior and the MMS have been very
cooperative in responding to all of our requests for
information. They assure me--and I emphasize this--they assure
me that they can factually explain the situation and that there
is no $700 million shortfall.
However, the $700 million is not the only issue. The focus
here today is also on the more critical issue: the 1998 and
1999 leases and the billions that the U.S. Government may be
precluded from collecting. That is why we are here today and
have only one witness to establish the fact in this public
forum.
The subcommittee will be diligent in our oversight
responsibilities, depending upon the information we find here
today. We may followup with hearings that are focused on more
specific issues that need further analysis. We may focus on
legislation to correct errors that we discover here today or in
future hearings.
It is our responsibility to ensure that royalties are
collected according to the law and the intent of Congress. I
look forward to the hearing, Dr. Cruickshank's testimony today.
I ask unanimous consent that the briefing memo prepared by
the subcommittee staff be inserted into the record as well as
all relevant materials.
I would now yield to the ranking gentlewoman from
California for her opening statement, Ms. Watson.
[The prepared statement of Hon. Darrell E. Issa follows:]
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Ms. Watson. Thank you so much, Mr. Chairman. And I am sorry
I am just now arriving--conflicts. But I want to commend you
for scheduling this hearing today on the subject matter, and in
the 5 years since the Bush administration has taken office,
neither the Government Reform Committee nor the Resources
Committee has held a single oversight hearing on the management
of the Federal Royalty Program or on the validity of the
regulations governing collection of natural gas royalties.
So I want to thank the Deputy Director of MMS for attending
the first hearing of what should be several meetings to discuss
the issue.
Indeed with the gas and oil industry recording the largest
revenues in history, Congress must take a hard look at the
reasons for royalty relief. The fact of the matter is the
policy of royalty relief that the Congress passed was an unwise
policy. But the oil companies convinced this Congress to do so,
and they have convinced the administration to allow it to
continue.
President Bush was quoted in the April 9, 2005 New York
Times, ``I will tell you with $55 oil, we don't need incentives
to oil and gas companies to explore. There are plenty of
incentives.''
The Bush administration recently acknowledged that the
further expansion of their oil royalty relief program was not
necessary. Unfortunately, President Bush did not go to such an
extent that he insisted that royalty relief be taken out of the
energy bill he just signed.
The American taxpayer is the victim in this situation. I
understand that there is an accounting controversy surrounding
the math that the New York Times used to calculate a $70
million--excuse me--$700 million, in other words, $7 billion
pool of uncollected royalties from the oil and gas companies.
So let us get down to transparency and utilize the proper
numbers. Why is there an unwillingness to allow a fair and
accurate exchange of numbers between government and private
industry? Has the manipulation of Enron taught us anything?
Moreover, the bottom line is those companies believed, as
the administration has said, that at a minimum, they were not
going to get relief from the payment of the rent to the
taxpayers if oil was over $35 a barrel.
As we all know, the world price of oil today is hovering
around $60 a barrel, and recently it has been on a high and as
high as $70. Now, how can we allow companies to exploit public
assets and then charge us extraordinary amounts to use the
products derived from those assets?
The American public is having a difficult time heating
their homes and putting gas in their cars. The country is at an
all-time deficit. Projections from the New York Times place
uncollected royalties at $65 billion in the next 5 years,
utilizing the plan proposed by the Department of Labor.
Leases without any royalty mechanism are driving the
largest revenue losses. Americans deserve an answer to the
currently inexplicable leases issued in 1998 and 1999 that do
not contain price thresholds at all.
Good public policy demands that Congress conduct real
oversight and protect the taxpayers' interests.
Recently, Representative Markey introduced legislation to
prevent any future royalty holidays for the oil companies. The
legislation is designed to seek and direct the Minerals
Management Service to renegotiate these leases so that it does
include the provision of a minimum of a trigger, hopefully
promoting a better royalty policy than that.
The bill dictates that companies who do not want to
cooperate with renegotiation should be barred from future bids
on the Outer Continental Shelf.
I am interested to hear from the Department of the Interior
if this is a step in the right direction. To their credit, some
of the major oil companies are struggling that, in fact, they
do owe the royalties and that there is a trigger mechanism.
Unfortunately, Kerr-McGee and apparently some other
companies have decided that they are going to challenge the
whole law.
They believe they are not obligated to pay any of these
royalties; also that there is no trigger in this law.
So, Mr. Chairman, I again want to commend you for your
leadership in bringing this issue to our subcommittee.
I look forward to the testimony today and subsequent
hearings, and I am as dedicated as you are in providing strong
leadership and advocacy on behalf of the American public and in
particular our drivers in California who have an extra
appendage and that is their automobiles.
So, again, thank you, and I yield back.
Mr. Issa. I thank the gentlelady. I would note for the
record that as far as our staff can determine, the first letter
that was received and part of the impetus for this hearing here
today came from a letter from the minority side, and it is the
first that we believe we received in those 5 years you spoke
about--on January 23, 2006, calling on both Chairman Pombo and
Chairman Davis to look into these issues. I wanted to make sure
that credit was given where credit was due. I am delighted to
be doing this. To be honest, I looked at those New York Times
articles and I looked at this request from the minority in
determining that this was an issue that should be quickly
scheduled, and we moved what was not on the agenda ahead so
that it could, in fact, be done right now. I hope that this
will be the first of many.
I would like to now yield 5 minutes to the gentleman from
New York, who also is very engaged in this issue and even has
his own legislation.
Mr. Higgins. I will waive an opening statement.
Mr. Issa. The gentleman waives an opening statement. So
with that, we can get to the meat of this.
Dr. Cruickshank, I am going to be brief and then give you
all the time that you need. But I would like to mention that
your Ph.D. couldn't be more appropriate, in that your education
in geological sciences from Cornell and from Penn State and
your mineral--Doctorate in Mineral Economics. Boy, we are
talking minerals and money here today--couldn't be more on
task. I note that you have been on the job since April 8, 2002,
when you were designated Deputy Director of Minerals Management
Service. I appreciate the administration providing you. I
appreciate your being here today.
Before I swear you in, I would ask unanimous consent that
your entire testimony be placed in the record in addition to
any materials that you may supply, including your PowerPoint
presentation. Without objection, so ordered.
It is the rule of this committee that all Members--or
certainly all people testifying and any who may be on your
staff that may give you advice, guidance, or may ultimately
answer a question also be sworn in.
So I would ask that you and anyone fitting that description
please rise and take the oath. Note there is only one.
[Witness sworn.]
Mr. Issa. Let the record show an answer in the affirmative.
Thank you very much, and, as we talked about earlier--
please have a seat. I understand that your testimony will be
supported by PowerPoint, we will then take questions and
answers, and without objection, take what time you need to do
both.
STATEMENT OF WALTER CRUICKSHANK, PH.D., DEPUTY DIRECTOR,
MINERALS MANAGEMENT SERVICE, DEPARTMENT OF THE INTERIOR
Mr. Cruickshank. Thank you, Mr. Chairman, and members of
the committee for this opportunity to appear today to discuss
the various issues that have been raised concerning oil and gas
royalties over the last month.
You have noted the plan. I would like to follow. I have a
PowerPoint presentation responding to the initial New York
Times article of January 23rd. And after walking through that,
I would then like to give some additional remarks on Deep Water
Royalty Relief--the history and mechanics of that program and
the issue of price thresholds and where we are today.
I will start with the PowerPoint. There are 5 issues raised
in that initial article that I would like to address. The 5
issues include the first, which is the statement that we could
have received $700 million more in royalties had we based
royalties on larger market prices; the issue of different
prices being reported to MMS and to the SEC. The third issue
noted that natural gas prices are higher now than in 2001, but
natural gas royalties are less. I would like to go on to the
reasons that has occurred. And the fourth issue raised in the
article was whether our valuation rules are aggressive enough
in seeking to collect royalties on the right basis, and finally
discuss the issue of our audit program.
So I will turn to each of those in turn.
But first, a little bit of background on royalties. Royalty
is the public share of the value of minerals produced from
Federal lands. For oil and gas leases, the royalty rate is
generally 12\1/2\ percent as a minimum royalty rate in statute,
but there are authorities to charge higher royalty rates or to
reduce royalties below that 12\1/2\ percent on occasion.
The value, for royalty purposes, is based on the value of
the production at or near the lease. And that is based on 85
years of practice, of statute, of regulations, of provisions in
the lease terms themselves and of judicial decisions.
The basic royalty equation is the value of the royalty
production times the volume sold times the royalty rate. The
value of royalty production again is based at the lease,
though, and often then does not reflect the price at a market
center that may be some distance from the lease.
In those cases, where you are selling at some distance far
from the lease, you are allowed to deduct your costs of
transporting the production from the lease to the point of
sale.
So the value for royalty purposes is the market price,
minus what you are allowed to deduct for your cost of
transporting to the point of sale, and for natural gas, you may
also take deductions for processing that gas to take out
royalty bearing liquids.
I would like to start by addressing the issue of the
potential $700 million shortfall in royalty collections.
That number arose out of data on our Web site, but the
numbers were used in a way that it was really not consistent
with what the data on the Web site contained.
What the New York Times did was basically use the data on
the Web site to calculate an average value for natural gas
produced in fiscal year 2005, compare that to other market
prices, to come up with the $700 million shortfall.
But our data on the Web is really not tied to the dates or
month of production. Rather, it is based on when we receive
payment. Our royalty management program is one that is charged
with collecting money and disbursing money, and the data that
we put on our Web site really tracks the cash-flows, if you
will--the money, when we receive it and when we pay it out,
rather than tying it to the year in which it was actually
produced.
What typically happens in the oil and gas industry is that
there are a lot of adjustments after the initial royalty
payments. Royalties are generally paid 30 days after the month
of production. But it could be many months, and in some cases
years before those numbers are actually locked in stone by the
companies. There can be a variety of reasons for this--related
to the number of partners on a field, the number of fields
tying into a pipeline, the number of pipelines tying into
processing plants. And at each stage, the owner of the pipeline
or the processing plant needs to allocate the production
volumes back to the various entities. It often takes quite a
long time for companies to really finalize what the proper
volumes were on which royalties are based.
In addition, when we take compliance actions against
companies, we are telling them also that they need to correct
the reports that they submitted previously.
Under the Royalty Simplification and Fairness Act of 1996,
companies are allowed by statue 6 years to make adjustments to
their initial reports on royalties.
What we find is that the data that we have for any fiscal
year often includes a lot of reports for prior fiscal years.
The 2005 data that the New York Times used included by volume
24 percent of the transactions were from prior years, when
prices were lower. And as a result, that tended to bias the
price that was calculated using that data.
This slide shows the New York Times approach. They took the
sales volume and sales value on our Web site to calculate the
$5.62 average value, compared that to the Energy Information
Administration's wellhead price for the same time period, of
$6.45, and basically that price difference applied to the
production volumes, and the royalty rate comes up with the $700
million difference.
Now, what we did is we recognize that the sales volumes
used in that calculation included by volume 24 percent
transactions from prior years. And so we removed those years
and recalculated the numbers using the same method as the New
York Times, but including only those volumes sold--produced and
sold in 2005, so that we were calculating an average value for
2005 production rather than an average value that encompassed
several years.
When you do that, when you remove those prior year
adjustments, you end up calculating an average value reported
to MMS of $6.59 rather than the $5.62 that the New York Times
reported.
That average value is above the benchmark the Times used of
$6.45. There really is no price differential between the market
price and the values reported to MMS; therefore, there is no
$700 million shortfall.
Mr. Issa. Just to interrupt briefly.
Mr. Cruickshank. Yes.
Mr. Issa. Would it be amenable to you--and you can continue
through your PowerPoint, but I think on behalf of both the
majority and the minority staff if the information you have as
complete as possible for as many years that shows a pattern of
accrual versus cash basis, which is what I understand you are
saying. If you could provide us with the data so that both
sides of the staff could independently look at the materials
that would probably be good. I think as much as I accept how
this problem occurred, ultimately I think either somebody on
your staff working with the majority and minority staff or the
raw data, one way or the other, and the former is preferred,
would allow both of us to get a comfort level--and I take you
at your word--that this is just the difference between the ease
of posting cash versus the complexity of providing the accrual
system in real time to a Web site. But I think since this is
not primarily what this hearing is about today, but we do have
to have a comfort level that all moneys owed are being
collected that we could do a lot of this offline--if that is
acceptable?
Mr. Cruickshank. That is fine. We will be happy to make
that data available.
And as you noted, because of these adjustments that we get
every month, posting accrual data would be difficult because we
would have to be constantly changing it.
Mr. Issa. I understand. Please continue.
Mr. Cruickshank. I do want to caveat the numbers I just
gave. Because of these adjustments, the numbers we used for
2005 clearly will change over time, as companies adjust their
2005 reports over the coming couple of years. So the $6.59
represents a snapshot of the data as we have it today, and that
may vary somewhat as we get additional information that is more
representative of the value that we are paid than the $5.62,
which encompasses an average over several years as opposed to
just 2005 sales.
The second issue raised in the New York Times had to do
with the difference in values reported to MMS and to the
Securities and Exchange Commission.
The difference really is the basis of the different
requirements of the two organizations. But the prices are not
inconsistent. SEC requires companies to report the average
gross sales price of all their final sales within the country.
This represents a composite of their sales from Federal
leases, State leases, private lands, and it is a mix of sales
at the lease, at market centers, and in some cases farther
downstream, closer to the end users.
In addition, SEC does not allow companies to take any
deductions for transportation or processing costs from the
prices reported to SEC.
For MMS, we also are receiving a variety of prices that get
averaged together. Some of these sales values are from sales at
the lease, where transportation is netted out before the value
is determined.
In other cases, we are receiving reports of prices from the
market centers, and the transportation deductions are taken
elsewhere.
As a result, what you have is different reports for SEC,
each company's report reflecting its own particular portfolio
of sales. For MMS, you have an aggregate of all companies'
average sales values from Federal leases, but many of them
reported with transportation deducted, which is not the case
for SEC.
So you tend to find some variations in the prices simply
because of the different rules about what companies are
supposed to report to the two agencies. The prices are
generally consistent with each other when you focus on similar
time periods, but there are variations because of the different
portfolios that individual companies may hold in terms of where
their gas comes from and where they sell it.
The third issue relates to why natural gas royalties are
not higher in 2005 than they were in 2001, given that natural
gas prices are so much higher.
The reasons here are several. I am going to walk through 5
reasons in particular, but they basically relate to how the
world has changed from fiscal year 2001 to 2005. There is less
gas being produced from Federal leases now than 5 years ago.
That gas is coming from different leases, leases that have
different royalty rates, different royalty relief terms, and
coming from parts of the country with different prices.
So I am going to walk through each of these reasons. But
what they will total up to is about $1.3 billion in royalty
value. In other words, if the world did not change between 2001
and 2005 other than the price of natural gas, we would have
expected to see about $1.3 billion more in royalties than we
did see in 2005.
These changes that I am going to talk about are responsible
for about that much difference in the royalties that we
collected.
The first reason has to do with just a general decrease in
the amount of natural gas produced from Federal leases over
time. This chart shows that decline between fiscal year 2001
and 2005, and the difference is about 1 trillion cubic feet in
natural gas.
The largest portion of this just reflects the general
decline in the amount of gas being produced from Federal leases
over time, but a significant component as well has to do with
shut-ins because of hurricanes, staring with Hurricane Ivan in
2004, whose effects were felt well into 2005, as well as 4
other named storms during 2005. We had about 340 billion cubic
feet of natural gas that was shut in due to hurricanes. That,
combined with the general decline in production from Federal
leases, amounts to the 1 trillion cubic foot decrease in
natural gas volumes over time.
Using the New York Times benchmark of $6.45, the royalty
value of that gas is equivalent to about $884 million, and is
the largest single reason for the change in the amount of
natural gas royalties collected between the 2 years.
The second issue deals with the fact that not all leases
are created equal. As I mentioned before, most oil and gas
leases have a one-eighth royalty rate, or 12\1/2\ percent.
There is one general exception to that, and that are leases in
the shallow water Gulf of Mexico have a royalty rate of 16\2/3\
percent, a somewhat higher royalty rate, recognizing that has
been very prolific area for natural gas production for over 50
years, and was able to bear a higher royalty rate.
However, because it has been producing for a long time,
there is just simply not as much natural gas left in the
shallow waters of the Gulf of Mexico. As you can see from the
yellow bars on this chart, production from shallow waters of
the Gulf have been falling. That decline actually started in
1990 and has been fairly steady over time.
Part of that decline has been offset by an increase in
production from deep water Gulf of Mexico leases that have a
one-eighth royalty rate. So we have had a shift in the share of
production, an overall decline in production, but then a shift
in the share of production from leases with a one-sixth royalty
rate to leases with a lower one-eighth royalty rate.
As a result, the average royalty rate for offshore
production has declined over the last 5 years, from 15.6
percent in 2001 to 15 percent in 2005.
That change in average royalty rate alone amounts to a
difference in royalty collections of about $136 million, and
this is solely from the fact that we are now getting production
from a different set of leases than we were 5 years ago.
But the shift in production from shallow water to deep
water also is tied to the other issue I will be talking about
today, the Deep Water Royalty Relief Act. I am going to return
to this topic shortly to talk about the history of this act and
the price threshold issue, but for purposes of the PowerPoint,
I just want to focus on the fact that during 2005, there were
247 billion cubic feet of natural gas produced from Federal
leases on which no royalties were paid. There are two reasons
for that, as you have noted. One is that the leases issued in
1998 and 1999 do not have price thresholds and so that
production has been royalty free. But then on other leases
issued in that time period, between 1996 and 2000, companies
have not paid in spite of price thresholds because they want to
challenge the legality of those thresholds.
As I said, I will return to those issues shortly, but
between those--because of those two reasons, there is about 247
billion cubic feet of natural gas produced on which no
royalties were paid. If royalties had been paid on that
production, it would have been about $200 million more in
royalty collections.
The third reason for this change has to do with greater
production on shore. While production from the Outer
Continental Shelf has declined in natural gas, it has grown on
shore, increased by about 17 percent. And this has been
predominantly in the Rocky Mountain region of the country.
There are two issues involved here. One is that these on shore
leases also have a one-eighth royalty rate rather than the
higher one-sixth royalty rate, but also the Rocky Mountain
region has generally lower natural gas prices than the Gulf of
Mexico.
This is largely due to the fact that as natural gas
production has grown in the Rockies, the capacity of pipelines
to take natural gas out of the Rockies to other markets has not
grown as rapidly. That is changing. New pipeline capacity is
being added, but right now production has grown more rapidly
than the pipeline capacity so that gas stays in the Rocky
Mountain regions and depresses the price of natural gas that is
sold in that area.
The average difference over 5 years between those two
regions is about one dollar per million cubic--per thousand
cubic feet of gas.
The combined effect of this shift to on-shore leases with
the lower royalty rate and a lower value, amounts for about $14
million in royalty collection difference.
The next chart simply illustrates the change in prices
between the two regions based on the market center index
prices.
The final reason explaining why royalty collections were
less in 2005 than might have otherwise been expected has to do
with hurricanes. This is not because of hurricanes being shut
in. We have talked about that already. But this has to do with
the fact that some companies had their royalty payment systems
based in New Orleans. So when Hurricane Katrina hit on August
29th, those companies were physically unable to make their
payments on August 30th and September 30th.
Those payments have since been made, but the money came in
during fiscal year 2006 and are captured in the 2006 data as
opposed to the 2005 data. We have gone back and taken a look,
and the money received in 2006 that normally would have been
collected in 2005 on natural gas is about $60 million.
So these 5 reasons together, we estimate account for about
a $1.3 billion royalty difference. If none of these things had
occurred, we would have collected about $1.3 billion more in
royalties because of the price difference in natural gas. But
the world has changed over the last 5 years and our royalty
collections reflect that.
The fourth issue raised in the article has to do with
whether our valuation regulations have been relaxed over the
last few years in terms of the way we collect royalties.
The easiest way to respond to that is to actually take a
look at each of the individual rulemakings that we have made
over the last few years. With each of those rulemakings, we are
required to do an economic analysis that is shared publicly to
receive comments on, and that analysis is supposed to try and
estimate what the impact on royalty collections will be from
the changes in regulations.
For oil, in 2000 and then again in 2004, we made
adjustments to our Federal oil valuation regulations, which
define how royalties are to be paid on oil. Those rules dealt
with changing the basic valuation, the basic prices that are
used for determining value.
The first of those rules was estimate to provide an
additional $67 million in royalty collections, based on prices
of that day. The modifications in 2004 were expected to be
revenue neutral; perhaps raise a little bit of money, but
generally thought to be a revenue neutral change.
With respect to natural gas royalties, the focus there has
been on what companies are allowed to deduct for transportation
and what they are not allowed to deduct. We spent some time
trying to clarify what is deductible and what isn't. And again,
the regulatory analysis for that rule shows that royalty
collections will increase as result of the rule changes
relative to what they would have been if we had not made the
rule change.
That is true for the Indian Gas Regulation as well, so in
general all of the rulemaking that we have done over the last 5
years on--for royalty collections for valuing oil and gas for
royalty purposes have resulted in either no change in the
amount of royalties collected or increases in the amount of
royalties collected and are not consistent with the idea that
we are somehow relaxing the standards on which we are basing
royalties.
The fifth issue raised in the article has to do with our
audit and compliance program and how our resources may have
changed over time and how the number of audits we have done has
changed over time.
This page in the presentation shows the basic data. Our
Office of Inspector General has gone over this page, and these
numbers are consistent with what our Inspector General is also
reporting on these issues.
As you can see, the number of audits completed has jumped
around quite a bit, but there really is no apparent trend. The
number in 2005 is the highest of the last 5 years, but that, in
part, reflects the fact that we had a major initiative in 2005
to try and close out a lot of very old and dated audits, so
that number is a little higher than we would normally expect to
see.
But generally, we have been able to maintain the number of
audits that we are starting and working on, and since every
audit takes a different amount of time to complete, the audit
completion data jump around a lot. But there is no trend there
in either direction, up or down. We have been able to maintain
the number of audits we are doing, and I would note that the
audits on this line are full audits, following the Government
Accounting standards, the Yellow Book standards for conducting
audits.
Our funding has gone up for our audit and compliance
program by minor amounts, from $32 million to $35 million over
the last 5 years, which we consider to be a pretty good record
given the budget times that we are in these days.
What I will note, though, is that the article was correct
in noting that we have fewer auditors working now than we did 5
years ago. The main reason for that is the growth in our
royalty in-kind program. The royalty in-kind program rather
than getting our royalties as cash payments from the companies
we actually take our percent share as production. We take the
oil or we take the natural gas, and we sell it ourselves at the
market centers for market prices.
This results in a much easier compliance process. We still
have to go out and make sure the companies gave us the right
volume of oil, but we no longer have to see whether they used
the right value in calculating royalty--whether they took the
right deductions.
The audits are far simpler. There is a lot less to look at.
In 2005, we took about 80 percent of our royalty oil in the
Gulf of Mexico in kind, and we are up to about 30 percent of
our natural gas royalties being taken in kind out of the Gulf
of Mexico. These are substantial volumes, and they have allowed
us to shift audit resources away from some of these offshore
leases. Some of them have been moved to compliance for on shore
leases, but it is also allowed us to reduce the number of
auditors overall.
Again, this does not reflect any less coverage. It reflects
the fact that royalty in-kind has provided some efficiencies
that allow us to reallocate our resources.
Finally, I would note that the article made mention of an
Inspector General report in 2003 that suggested a lot of
improvements to our internal controls over the audit program.
As a result of that report, we completed a 39-item action
plan for improving the audit program. And when we finished
that, we brought in an independent CPA firm to review our audit
program, the same firm that had been critical of our program
along the same lines of the Inspector General a few years
before.
That independent review has given us a clean bill of
health, an unqualified opinion with no weaknesses, no
reportable conditions, no management letter--about as good as
you can get from an auditor.
So we are comfortable that the issues the IG has raised
have all been fixed.
As of last year, we were able to cover through our
compliance program about 71 percent of the revenues collected
for the audit year we were targeting, which is a very good
sample.
And just to close the PowerPoint, I would like to note that
the Government Accountability Office has taken a look at this
PowerPoint. They have been asked to dig into the numbers behind
it, and we shared our work papers with them, and they are
preparing a briefing this afternoon. GAO generally agrees with
our conclusions here. They have not had time to dig into the
raw data themselves, but they believe our approach in this
response is reasonable. They believe our conclusions are
correct. They agree with the reasoning here, though, they have
not actually opened on the exact numbers within this report.
With that, I would now like to turn to the issue of Deep
Water Royalty Relief and briefly talk about the history and
purpose of that act and the price threshold issues with which
we are dealing with today.
The Deep Water Royalty Relief Act was passed in 1995 and
for purposes of the hearing today, there are 2 sections of that
act of importance.
Section 303 of the act authorized the Secretary to issue
leases with royalty relief. This language basically said that
the Secretary could issues leases that provided royalty relief
in the form of a volume or value of royalty-free production.
Once that volume or value was produced, royalties would be due
on all additional production after that fact.
In addition, that section authorized the Secretary to vary
relief based on market prices, and that is the authority for
the price thresholds that limit the applicability of royalty
relief when prices are high.
Section 304 of that act then went on to direct the
Secretary to issue leases using that system, that the
Department was required to issue leases in the Deep Water Gulf
of Mexico for all years, 1996 through 2000, with royalty
relief, and the act specified the amount of royalty relief we
were to apply. It ranged from 17\1/2\ million barrels to 87\1/
2\ million barrels of oil equivalent.
That section, Section 304, made no reference to price
thresholds.
The mechanics of this relief is that the suspension volumes
granted by the act allow that production to come online royalty
free, but once that suspension volume is produced, then
royalties will be paid on all additional production. Where
there are price thresholds on the leases, that limits the
applicability of the royalty relief. When market prices are
above the threshold level, royalties are due on production and
that production counts toward the royalty relief volume, the
other royalty relief provisions notwithstanding.
The purpose of this act, as you noticed, Mr. Chairman, were
to try and encourage companies to move into an area of the Gulf
of Mexico that was viewed as very high cost and very high risk,
but with substantial potential for new sources of energy. And,
as you noted, this was a time when oil and gas prices were
fairly low.
For the Deep Water Gulf of Mexico, the geological concepts
and the technology had not yet been proven for whether there is
actually substantial oil and gas there to be found.
The effects of this act were two-fold: one, the relief made
leases very much more valuable than they would have been in the
absence of relief and for leases issued between 1996 and 2000,
this increase in value we believe resulted in about $2 billion
in bonus bids, up-front bonus payments for these leases that
would not have been received in the absence of royalty relief.
In addition, oil and gas production from Deep Water has
grown dramatically over time. Since the enactment of the Deep
Water Royalty Relief Act, deep water oil has grown by about 400
percent and natural gas has grown about 340 percent over that
time period.
Today, deep water Gulf of Mexico accounts for about two-
thirds of the oil and over one-third of the natural gas coming
from the region.
So it has been a very successful region of the country in
terms of trying to promote additional supplies of oil and
natural gas, and we believe Deep Water Royalty Relief
contributed to that success.
When the mandatory provisions of the act expired in 2000,
then we were left simply with Section 303 of the act that gave
discretionary authority to issue royalty relief.
At that time, the Department chose to continue royalty
relief, but to scale it back. They eliminated royalty relief in
some water depths and reduced the volumes to 5 to 12 million
barrels of oil equivalent depending on water depth. In
addition, all of those leases were issued with price
thresholds, so at today's market prices every deep water lease
that is producing--that was issued from 2000 is paying
royalties.
Finally, we come to the Energy Policy Act of 2005, which
again made royalty relief mandatory in the Deep Water Gulf of
Mexico. We had been making sale by sale decisions on whether to
have royalty relief, but the Energy Policy Act mandated that we
continue that relief for the next 5 years in the Gulf of
Mexico. It adopted the range of royalty relief that we had been
using--the 5 to 12 million barrels, but it added an additional
tier for deeper water of 16 million barrels of royalty relief.
Finally, that act continued the policy of allowing set
carry to set price thresholds to limit the applicability of
royalty relief and that authority is explicit in the Energy
Policy Act.
Turning to price thresholds, as I mentioned, when this act
was originally enacted, we had to sit down and decide how to
implement it, and the Secretary at that time determined that we
would have price thresholds on all the leases issued between
1996 and 2000.
But somehow, as you have noted, for the leases issued in
1998 and 1999, those price threshold provisions are not in the
lease.
I have looked at all of the decision documents related to
lease sales in that time period, as well as all the lease sale
documents themselves, and what I have concluded is that there
was no affirmative decision to take price thresholds out. It
was clear in 1996 a decision was made to have price thresholds
as part of the Deep Water Relief clauses in these leases.
When the Director of MMS and the Assistant Secretary were
asked to make decisions on the lease sales in 1998 and 1999,
they were not asked to change that provision. There is nothing
in those documents asking for the elimination or removal of the
price threshold clauses. Indeed, those documents suggest Deep
Water Royalty Relief would continue as it had in 1996 and 1997.
Now, with the passage of 8 years of time and a large
turnover in staff, it is impossible to say exactly what
happened, but as near as I can piece together, over the same
timeframe, we were putting regulations in final form that
implemented the Deep Water Royalty Relief Act.
The language in the lease documents themselves that refer
to this program were being revised to reflect the new
regulations, and in making those revisions it appears that the
price threshold language was inadvertently dropped out for
those 2 years.
Clearly, there is a lot of oil and gas production tied up
with this. Looking back over the last several years, if the
price thresholds had been in place on those leases, we would
have been collecting royalties on about 475 billion cubic feet
of natural gas and over 50 million barrels of oil that has been
produced royalty free because of the absence of those clauses.
That is certainly worth several hundred million dollars of
royalty collections, and if prices remain high, will easily
move into several billion dollars over the coming years.
In addition to that, we are facing a legal challenge to
thresholds, to price thresholds for leases issued in 1996,
1997, and 2000.
On these leases, because of the price thresholds, we have
already collected over $425 million of royalties with about
$100 million still due. That money that is due is largely from
companies that are challenging whether we could have put price
thresholds on in the first place. We clearly believe we have
the authority to do so because of Section 303 of the Deep Water
Royalty Relief Act. But clearly, there is a lot of money at
stake here, not just the $500 million or so looking backward,
but if price thresholds remain--if prices remain high as they
are today, then clearly there are billions of dollars in
royalties that will be collected because of those price
thresholds in future years.
Because of the amount of money at stake, we are going to
vigorously defend our authority to have price thresholds in
these leases so that at the end of the day, we will be able to
collect all of those amounts, plus interest.
But this is clearly a piece of litigation where there is a
lot of money at stake, and we will vigorously defend our
position on this.
That concludes my remarks, and I would be happy to answer
any questions that you or members of the committee may have.
[The prepared statement of Mr. Cruickshank follows:]
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Mr. Issa. Thank you. That was very informative. As Henry
Kissinger once said to the press when he appeared on the eve of
the President's resignation as the only person trusted to meet
the press, he looked at them and said, ``I hope you have
questions for my answers today.''
I will tell you have provided many answers to my questions
before I ask them. Certainly, the first and foremost was why
were these thresholds not included in 1998. But I do have a
followup on that I am concerned about.
There is a trail, there is an electronic trail--there are
tapes on who drafted, when it was redrafted, in a Word document
or equivalent--there is a way to piece back together when it
disappeared from a draft that ultimately was presented. Has
there been an investigation either by your own agency, the
Department of Justice, or any other agency to try to ascertain,
if you will, who, what, where, when this actually occurred?
Mr. Cruickshank. Not to that level of detail at this point,
Mr. Chairman. We have gathered the final documents that were
used for decisionmaking and for the contracts themselves and
looked at those. We have not at this point gone back and tried
to locate any preliminary drafts.
Mr. Issa. At least for this Member, I would think that if
not your agency, then the Department of Justice would have a
reason to say this is too many dollars and too important a
provision not to find out whether, in fact, somebody did it for
a beneficiary purpose that would be outside the law and would
leave you with that for today.
But certainly, I don't think this committee is going to
leave it in our oversight capacity.
I would ask also that you would submit for the
subcommittee's review copies of the leases entered into in 1998
and 1999, as well as examples of leases for 1996, 1997 and 2000
so that we would have, if you will, anecdotal examples of the
very leases. I know they are public record, but I would
appreciate it if you would provide them.
Mr. Cruickshank. We will do so.
Mr. Issa. You mentioned the leases post the 19 or the 2005
mandating, but you didn't mention whether or not at today's
prices they would or wouldn't be paying royalties, assuming
they were producing so quickly. Do you have an opinion on that?
Mr. Cruickshank. For the leases issued from 2000 on in the
Deep Water Gulf of Mexico, if they are producing, they would
all be paying royalties today.
Mr. Issa. Well, you mentioned that. But the latest act
where we remandated, if you will, the elimination--I got the
first part of it. I guess it is our energy bill that you now
have new requirements. You mentioned that you have made the
additional reductions subject to price levels, but you didn't
mention the price levels versus today's price levels.
Mr. Cruickshank. I don't off the top of my head know what
the price thresholds are where you're using in all of the
leases, but all of them are well below today's market prices.
Mr. Issa. So it would be fair to say that if they produce,
when they produce, at today's prices, they would be fully
royaltied and the provision of our act would not be place at
these price levels?
Mr. Cruickshank. That is correct.
Mr. Issa. Great. These leases and one of the reasons I ask
for copies, they are boilerplate, aren't they?
Mr. Cruickshank. Yes. There--the way that--there is a
standard form for the lease, and what the decisionmakers are
asked to do is to really fill in the blanks as to what
geographic areas, what minimum bids, rental rates, royalty
rates--what terms--stipulations we put on operations to protect
the environment. So the basic lease form itself is boilerplate,
with some fill in the blank language, and then there are
addendums to it, attachments to it that spell out some of these
additional details on a sale by sale basis.
Mr. Issa. And these always initiate from your side? In
other words, you are the landlord. You deliver the lease?
Mr. Cruickshank. That is correct.
Mr. Issa. And I am assuming that in the contract way that I
am familiar with, you send them electronically to the
applicant. They make changes, send it back to you, and there is
a series of underlines or some other way that each side is
looking at the changes made in those documents?
Mr. Cruickshank. There is no negotiation. These are leases.
They take them or leave them.
Mr. Issa. Excellent. So that is all the more reason that I
also would appreciate, to the extent that you can reconstruct,
the boilerplate that you were giving out in each of those years
in its raw format; in other words, with no names or addresses
filled in. And if it changed mid-year or at some point, you can
determine a before and after, because I guess it is possible
that it was one way in January and another way in February. I
am not sure, but I would appreciate knowing that.
Mr. Cruickshank. OK. We will be able to track through all
the changes in those documents for you.
Mr. Issa. Excellent. And this is a difficult question
because I realize you came on board in 2002, but to the best of
your knowledge, is there any written guidance from anyone in
the Department to omit those price thresholds in 1998 and 1999?
I believe you said no.
Mr. Cruickshank. There is not. And actually, I took my
current job in 2002, but I have been with MMS since 1988.
I did work on the regulations implementing the Deep Water
Royalty Relief Act, and I am not aware of any guidance and
could not find any directing us to remove those provisions.
Mr. Issa. And likewise, you would know of no written or
oral instructions that may have come from the White House, the
Secretary's office, or any other government agency at that
time?
Mr. Cruickshank. There has been nothing in writing, and I
am not aware of anything orally.
Mr. Issa. You previously testified that you felt that this
omission was, if you will, a word processing error during the
revision.
Mr. Cruickshank. I believe that what happened is--yes, the
addendums to the lease were being changed to reflect the fact
the regulations had changed and in so doing, the price
threshold language came out for those 2 years. I have not been
able to ascertain who may have actually pushed the button or
why they thought that language could come out. My understanding
is people believed at the time the price threshold still
applied, but the revisions clearly do not have that effect.
Mr. Issa. Now, I know that every lease is a little
different, but would it be correct to say that during the
periods before and after the 1998 and 1999 omission that leases
were substantially similar in their value, exploratory value to
their price, meaning that there wasn't a discount or a price
increase that came with these leases that didn't have this
fairly significant threshold included in them?
Mr. Cruickshank. Are you asking about whether there is a
change from 1997 to 1998 because of the change in that
provision?
Mr. Issa. Well, usually what--in most contracts the
question is was there a quid pro quo? Was there, in fact, some
recognition of a value difference for this or was this given
away for free by its omission?
Mr. Cruickshank. Well, there was certainly recognition of
royalty relief that was factored into how we determined whether
to accept bids or not and are reflected in the increased
bonuses we received.
There was no additional premium placed on these leases in
1998 and 1999 due to the lack of the price threshold
provisions, in part because I don't think we realized at the
time the price thresholds didn't apply; and certainly just
looking at the track record, the amount of leases issued in
those 2 years actually declined from the previous 2 years.
Mr. Issa. They didn't know----
Mr. Cruickshank. So it is----
Mr. Issa. OK. And this question I am particularly
interested in, and I think it is probably the most important
one I will ask today. Do you believe that the lack of price
thresholds during 1998 and 1999--this follows up on what you
have said is in conflict with the overall intent of the act?
Isn't it true that Section 303 and 304 of the act should be
read together and not to the exclusion of one another? In other
words, and I found this by reading 04 and then going seeing how
it read on 03. In other words, doesn't Section 304 merely
define Section 303 by providing the specific volume suspensions
outlined in the bidding section in 303?
Mr. Cruickshank. That is how we read the act, and for that
reason, we believe that the authority in 303 to have price
thresholds remains intact under that construct.
Mr. Issa. The assessment at this point is or isn't that
you--as to 1998 and 1999--this perhaps $7 billion or more that
over the life of the lease is you will not get because of this
absence of writing, do you believe that you have a right or any
opportunity or any chance under existing law to collect those
lost revenues?
Mr. Cruickshank. I am not a lawyer, but my understanding is
that these leases represent contracts entered into by two
parties and cannot be unilaterally changed by one party or the
other.
Mr. Issa. Well, I think I will ask the opposite, though,
isn't it true that the parties, many of the same parties are
disputing what is in the language of the other 3 years--well,
basically saying a deal is a deal unless we didn't get the
better part of it, in which case a deal isn't a deal and we
want to set aside the contract?
Mr. Cruickshank. Well, we are being challenged on the price
threshold provisions for those other 3 years, and presumably on
the grounds that they feel that the contract is inconsistent
with the law, in which case I suppose the law would override.
Mr. Issa. Well, isn't it true that the absence of those
thresholds may be in conflict with both the intent of Congress
and the stated policy of your department?
Mr. Cruickshank. Well, Congress certainly made price
thresholds discretionary, and at the time these leases were
being put in effect, oil and gas prices were much lower, and I
am not sure if people really gave a lot of thought to when
thresholds might kick in. That clearly was--had been the policy
of the Department to include price threshold provisions and
certainly those do exist in every other year.
Mr. Issa. OK. Now, we are going to have to make one quick
vote and come back. And fortunately, it is only one vote. Ms.
Watson, do you want to come back and ask a series of questions?
Ms. Watson. I just have one, because you have covered many
of the questions I was going to ask.
Mr. Issa. I am trying to get to as many of your questions
as I can. With that, I would yield to the gentlewoman from
California.
Ms. Watson. Thank you. I am perplexed because the oil
industry is enjoying the highest profits in history. And I
really feel it was outrageous that the oil industry benefited
after Katrina, and their quarterly reports showed benefits in
the billions of dollars.
My questions go to the audits. In your testimony, you
indicated that compliance funding has increased slightly in the
nominal dollars since fiscal year 2001. Yet, the New York Times
reported today that spending on compliance and asset management
has fallen since 2001 from $51.3 million to a proposed $43.1
million in fiscal year 2007.
Could you explain the difference in those numbers--and the
thought came to me when you said you had been there since the
1980's and now you are the Chief, I guess Director. You have to
really watch what you wish for. You might get it.
But anyway, if you can explain that and then if you can
followup and let us know us know why MMS auditors and the
tribal auditors have been cut, the number of auditors has been
cut. So you can tie those together. Those are my questions,
because I think the Chair is raising all the issues that I
wanted to raise in addition.
Mr. Issa. We are a team.
Mr. Cruickshank. OK. On the first issue of the dollar
amounts, the New York Times was reporting a budget line item
that captures not only what is done in the terms of audit and
compliance, but also has the budget for our Office of
Enforcement, which is the office that goes out and bills and
collects the money, as well as some IT system dollars in it.
The numbers that were in this PowerPoint reflect the
dollars actually spent on audit and compliance activities, and
the Office of Inspector General has confirmed those numbers.
I would suspect that the number of auditors--the number of
audits for Indian leases has not changed. The number of State
auditors has not changed dramatically. It is within 2 or 3 or
where it was and really reflects an on board number rather than
an FTE number.
Where there has been a decline in the number of auditors is
on the Federal audit staff, and that reflects the growth in the
royalty in-kind program in the Gulf of Mexico, because we don't
have as many audits to do offshore now because of the RIK
Program, we have been able to decrease the number of auditors
looking at offshore leases.
Ms. Watson. I would think that because we have all these
different ways of calculating, and as you said, the Times
calculated one way and you calculated another way and so on, I
would think that you would need more auditors to be able to set
the standard. The Markey bill I think has some provisions in
that would be useful and helpful, but I do think you need a
team so MMS can catch these differences beforehand.
I don't feel that the answer is satisfying, because I do
think that a lot rests on your shoulders and because you have
been sued and I understand that the awards have been quite
large. We might want to do a better job of making the figures
kind of coincide with what the reality is and so that was my
response, Mr. Chairman. I will be going to the floor, and I
don't see that I need to return, so you can finish asking your
questions at this time.
Mr. Issa. Excellent.
Ms. Watson. Thank you so much, Mr. Chairman. I yield back.
Mr. Issa. Thank you very much, and because several Members
have expressed an interest to supply questions in writing, I
would ask would you respond to those in writing. What I will
do, because I think we have made a fairly good jab at the
record here today, although I think that we are going to ask
you to come back, undoubtedly, sometime in the future. I would
ask that the record, by unanimous consent, be kept open for 2
weeks, subject to extension based on Members who do ask you
additional questions and your response.
I would like to thank you for being here and for dedicating
your time. I am going to save you the greatest burden of all,
which is hanging out here while we wander off to vote and then
come back. Whenever possible, it is nice to do it in one felled
swoop.
So with the reservation that undoubtedly, we are not done,
but we are certainly for today and the foreseeable future, this
hearing is adjourned. Thank you.
[Whereupon, at 3:11 p.m., the subcommittee was adjourned.]
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